Financial Innovation Key to Future of Homeownership (U. S. News & World Report)

U. S. News & World Report
(3/11/2013 11:50 AM, Jason Gold)

The housing bubble and ensuing financial crisis not only wreaked havoc on the U.S. economy, but it also shook public confidence in financial markets and robbed Americans of their faith in homeownership as a stable iconic pillar of middle class security.

Much of the fallout can be blamed on the exotic financial "innovations" hawked by Wall Street in the run-up to the financial bust: "liar loans," where no verification of income was required; synthetic derivatives, whose highly speculative design put the entire financial system at risk; and home equity lines of credit that exceeded the value of homes by up to 125 percent.

Today, housing prices are finally rising and the stock market is going gangbusters. But the idea of "financial innovation" retains its negative aura. That's a problem, because just as there are good and bad witches in Oz, there's good and bad innovation on Wall Street.

Good financial innovation is transparent, easy to understand, reduces risks, and benefits all market participants—not just savvy insiders. Bad financial innovation is opaque to small investors, emphasizes debt over equity and risk, and mainly benefits the financial services industry.

Take adjustable rate mortgages that reset after two years but include a five-year prepayment penalty. These loans guaranteed the borrower much higher payments after the reset, something many that borrowers were unprepared for, or a substantial penalty that sent the original loan amount soaring.

Still, we shouldn't overreact when it comes to new financial products or create a regulatory environment that stifles the right kind of creativity. Here are four ways "good" financial innovations can help—not hinder—homeownership:

1. "Underwater insurance": If the crisis taught us anything, it's that home values can plunge as well as rise and that when they do, underwater homeowners can't move if a better job opportunity appears elsewhere. But what if people who can't afford large down payments, but are perfectly responsible candidates for homeownership, could buy a modestly priced insurance policy (at its most basic, a derivative is a simple insurance contract) to protect against a downturn in home values? That policy could mean the difference between a better job and greater opportunity at wealth and mobility.

2. HomeK: a down payment savings account: One of the biggest hurdles to homeownership is the down payment, especially with the stricter mortgage underwriting standards adopted in the wake of the housing bust. To overcome that obstacle, 401(k) plans could be expanded to facilitate savings for down payments. Potential first-time homebuyers can set aside up to half of their future contributions to retirement accounts into a tax-preferred subaccount designated for down payments. And boosting overall savings would buffer homeowners against the risk of falling home values as well as the likelihood that entitlement reform will trim Social Security benefits.

3. REO to rental: REO (real-estate owned) refers to homes that a bank takes back from a borrower after a foreclosure. Despite improvement in the housing market, many REOs still exist, which has given cash-rich investors a chance to capitalize on rising rents and low interest rates. Recently even mammoth hedge funds and private equity investors have entered the fray, snapping up bargain-basement-priced homes by the thousands and helping fuel the housing comeback.

4. Assumable mortgage: An assumable mortgage allows a new borrower who qualifies for the terms of an existing mortgage to transfer the note upon purchase of the home. This idea seeks to minimize two of the biggest risks investors and lenders face in mortgage lending: early pre-payment and default risk. The Federal Housing Administration currently has mortgages that are assumable in certain cases and it's astounding they are hardly ever mentioned as more significant assets. With interest rates at historic lows—and conventional wisdom pointing to increases starting next year—an assumable mortgage with a fixed rate of 4 percent or less should add quite a premium to the price of a home. It's also something investors should embrace as well.